April 1, 2015

Longevity Insurance: Part 2 Qualified Longevity Annuity Contracts (QLACs)

On July 2, 2014, the IRS and U.S. Treasury issued final regulations regarding Qualified Longevity Annuity Contracts (QLACs) within Individual Retirement Accounts (IRAs) and Defined Contribution Pension Plans (DCPs – such as 401(k) plan accounts). Here’s what they are and what you need to know about them.

Background

Back in February 2010, the Department of Labor, IRS, and the Treasury Department issued a request for information regarding lifetime income options for participants and beneficiaries in retirement plans. As part of that request, they asked whether Required Minimum Distribution (RMD) rules affected sponsors’ interest in offering – and participants’ use of – lifetime income products, and whether changes to RMD rules should be considered to encourage the purchase of deferred annuities.

Not surprisingly, the insurance industry fell all over itself providing arguments for a change in RMD rules that would make it more attractive for participants to buy longevity annuities. The government also consulted economists who argued that the DCP focus needed to shift from returns to income – getting workers back to a world of some form of “guaranteed income” in retirement, as was the case when defined benefit (DB) plans were the norm.

The IRS/Treasury issued final regulations regarding QLACs on July 2, 2014. The final rules, intended in part to facilitate the purchase of deferred annuities, provide for:

  • no more than 25% of an account balance, up to a $125,000 maximum, may be used to buy a QLAC (i.e., spent on premiums);
  • these limits are applied to each DCP account separately, but can be aggregated for all IRAs (just as RMD calculations are);
  • distributions must commence not later than age 85 (the first day of the month following attainment of age 85);
  • prior to annuitization, the value of any QLAC in an IRA or DCP must be excluded from the account balance used to determine RMDs;
  • the $125K limit will be inflation-adjusted in future years in $10,000 increments in the same manner as other cost of living adjustments are made to pension limits;
  • the maximum age (85) may also be adjusted in future years to reflect changes in mortality; and
  • final QLAC regulations are effective as of and apply to contracts purchased on or after July 2, 2014.

In order to help with full disclosure, the final regulations provide that when the contract is issued, an employee or IRA owner must be notified that the contract is intended to be a QLAC. Furthermore, an issuer must file an annual calendar-year report with the IRS and provide a statement to the QLAC owner with information such as the name and contact information of the issuer, contract number, annuity start date or planned start date, premiums paid and the fair market value of the QLAC, among other items. The report will be similar to that provided on Form 5498 and must be issued on or before January 31 of the following calendar year. This report continues annually until the QLAC owner reaches age 85.

A Few Other Things to Know
While traditional IRAs, 401(k), 403(b) and governmental 457 plans can hold QLACs, Roth IRAs and non-governmental 457 plans cannot. In the case of Roth IRAs, since there are no RMD requirements for the owner, the need for special QLAC rules is moot. As for 457 plans, regulations require that non-governmental plans be unfunded, and the purchase of an annuity contract would violate this requirement.

The final regulations also allow for a Return of Premium (ROP) feature, which guarantees that if the annuitant dies before receiving payments at least equal to the total premiums paid, then an additional payment is made to the beneficiary to ensure that the total payments received are at least equal to the total premiums paid.

Variable, indexed or similar annuities do not qualify as QLACs (although the final regulations also state that the Commissioner may provide an exception to this rule in the future). Also, QLACs are not permitted to make available any commutation benefit, cash surrender value or other similar feature. The only death benefit permitted (other than an ROP) is a life annuity to a designated beneficiary.

We anticipate that QLACs may be attractive only to a very small subset of BOS clients. As we have discussed in the past, deferred or even immediate annuities can provide guaranteed income protection for investors of limited financial means who are at risk of running out of money (i.e., depleting their financial assets during their lifetime). In addition,

very risk-averse investors may find the option of locking in future “guaranteed income” attractive.

However, most BOS clients near or of retirement age are fortunate enough to have sufficient assets (including Social Security benefits) to meet their core income needs for the balance of their lifetimes based upon reasonable projections. Moreover, BOS professionals track projected sustainable spending for most clients near or in retirement and will always be on the lookout for situations in which annuities, QLACs or longevity annuities could play a valuable role. That said, while the ability to ignore the value of a QLAC when calculating RMDs is an attractive feature, it is not one sought by low-asset investors, nor is it significant enough for high-asset investors in most cases given the limited amount that may be invested under these final regulations.

There are some additional caveats when considering the purchase of an immediate or deferred annuity, or a QLAC for a retirement account:

  • QLACs aren’t likely to be a competitive estate planning tool for higher-asset investors since the very low return assumptions currently used by most insurance companies to calculate monthly annuity payments is expected to be surpassed in most cases by other investments;
  • men purchasing a single-life QLAC within a DCP might receive adverse pricing since they must be priced on a unisex mortality basis. Since women are expected to live longer, the products may likely be priced to their life expectancy tables, meaning lower payments for men than they would otherwise get in private policies outside of the pension plan;
  • since commutation of benefits or cash surrender values are not permitted, the choice to use a QLAC should be considered irrevocable; investors will lose access to these funds; and
  • all the usual caveats of buying any insurance product apply, including the investor’s reliance upon the financial strength and viability of the insurance company to “guarantee” retirement income.

Since QLACs are fairly new products and haven’t been widely publicized or reported on yet, many investors haven’t even heard of them. That is likely to change over the coming months and years. Should you wish to discuss whether annuities, longevity annuities, QLACs or other types of annuity products not discussed here are appropriate for you, please contact your BOS team.

Filed under: Investing

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